Return Predictability and Implications

We review the academic literature on the empirical phenomenon of return predictability and discuss its implications for the rebalancing policy of longterm investors.

Main findings

Many institutional investors fix the strategic weights of asset classes in their portfolios and frequently rebalance back to those fixed weights.

Samuelson (1969) shows that this is the optimal dynamic investment policy when certain restrictive assumptions are met, in particular when asset returns are identically and independently distribute random variables. In other words, it is the optimal policy when expected returns are constant over time, but essentially unpredictable.

However, the more recent academic literature indicates that return predictability is present across different asset classes. In the presence of predictability, rebalancing back to the fixed strategic weight is no longer optimal.

Long-term investors are likely to benefit from rebalancing to weights that take into account the time variation in risk premia, i.e. by increasing exposure to risky assets when premia are perceived to be high and reducing them when they are low.

Predictability is most likely related to discount rate variation (and hence risk premia). The risk premium view of predictability is supported by the observation that predictable variations in market returns are often related to the macroeconomic cycle.

Imposing economic structure on predictive relationships or using non-parametric approaches may yield more robust predictions with better out-of-sample power.